fbpx A Goldilocks Theory of Fiscal Policy - Ludwig Straub | Harvard Kennedy School

Excerpt

May 31, 2021, Paper: "When an economy is close to the zero lower bound on nominal interest rates, governments face a trade-off: excessively conservative fiscal policy risks persistently low output but aggressive fiscal expansion raises sustainability concerns. This study builds a framework of dynamic fiscal policy, showing that there exists a Goldilocks zone in which deficits are permanent but not too high, the nominal interest rate on government debt (R) is lower than the economy’s growth rate (G), government debt levels can be substantial, and deficits allow the economy to overcome weak demand to achieve potential output. The size of the Goldilocks zone can be estimated using empirically observed moments in the data, which suggest for the United States that government debt to GDP ratios can reach a maximum of about 250% in the Goldilocks zone, but the maximum permanent government deficit is only about 2% of GDP. In the model, R and G are endogenous to fiscal policy, which disciplines the ability of a government to boost deficits even if R < G. The Goldilocks zone is fragile: it can vanish in the face of a decline in potential GDP growth, a rise in aggregate demand, or a decline in income inequality."

Non-HKS Author Website - Ludwig Straub